Legalized pot – get in now, or wait?

Next July, if all goes according to plan, marijuana for recreational use will be legal in Canada. But while Canadians may be able to buy consumer cannabis come the second half of 2018, is now the right time to buy marijuana stocks?

What will legalized cannabis mean for investors? Analysts and advisors are split – while many see opportunities to get in early, others see uncertainty and suggest it may be better to wait.

Here are the views of two analysts who have been watching Canada’s marijuana sector closely – both the companies that grow and sell medical cannabis, which is already legal, and those that are poised to serve the coming recreational market.

Alan Brochstein is watching closely as Canada’s soon-to-emerge recreational marijuana market takes shape. His New Cannabis Ventures is a business-to-business news site specializing in the cannabis industry, and 420 Investor is an online community of investors focused on the sector.

“I think the move toward legalization is generally bullish, though there are challenges,” Mr. Brochstein says. “We don’t know what the taxes will be; we don’t know how recreational marijuana will be distributed in Canada. So there’s still a lot of uncertainty, but I think it’s going to be a good outcome.”

When recreational marijuana becomes legal, “I expect there will be a shortage of product for some time.” That’s good for producers.

“I think the market is starting to understand this better now. We had a big correction already. There was a run-up in November, 2016, and another one in April, 2017, and then it pulled back a lot – a lot of the names [major Canadian growers] dropped 50 per cent from their peak prices. But I think the fundamentals are sound.”

Investors may miss big opportunities if they focus only on the coming Canadian recreational market, Mr. Brochstein adds. “You may miss how to make sense of the valuations of some companies. Some of them will be participating in global markets [in addition to Canada], particularly in Germany. That’s a real positive for LPs,” or licensed producers, he explains.

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In Germany, with 81 million people, “they passed a law; [medical marijuana] will be distributed in pharmacies and covered by health insurance there. This is very promising. Right now they allow for only a limited number of imports, but they are in the bidding process now and there will be 10 importers.”

Canadian licensed producers will be in good shape because the German law will forbid buying from U.S. producers. Although several U.S. states allow recreational marijuana, cannabis is an illegal substance under U.S. federal law. “This really plays well toward Canadian producers,” Mr. Brochstein says.

There could be potential risks coming from Canada’s legalization if the law is written in certain ways, Mr. Brochstein warns. “If the tax rates are too high, it’s just going to keep the black market open longer and reduce opportunities for the legal market,” he says. The market might also be hampered if the distribution system is too restrictive … If it’s 100 per cent LCBO-type distribution, and the government sets wholesale prices, there could be a risk to producers that the wholesale price will be too low. It’s going to differ from province to province,” he says.

Industry players also face uncertainties about packaging. “Plain labels, without branding, can devalue these companies.”

Even bullish investors should be prepared for a “long, drawn-out process” before the winners and losers among producers become evident. “It’s not clear that this is going to happen on July 1 [2018],” Mr. Brochstein says.

It will happen eventually, though, he is convinced: “I think there will be a lot of trading opportunities over the next year.”

“We’ve been following the sector for some time now, and we’ve seen a lot of investor mania, where everything increases in value regardless of whether the business plan is sound,” says Mr. Zandberg, who covers small-cap growth companies.

“I’ve seen markets like this in the past. We caution investors to stick with the quality names that are proven market leaders at this stage.”

Investors should look closely at what marijuana companies say about their businesses in their prospectuses and promotional material. “I would stay away from companies that have no content other than press releases saying things like having ‘unique delivery mechanism for delivering cannabis’ to users. Often there’s no content other than that, and their product hasn’t been approved by Health Canada,” he says.

“We have seen some of these companies’ stocks double or triple in a very short time. But given the fact there are so many unknowns in this market, taking a chance on something that’s unproven and has no legal basis at this point is not where smart money is going.”

For the Canadian market, Mr. Zandberg is pondering “unknowns” such as “what types of products will be available and how much branding will have a role in the market.”

While Canadians already have experience with legalized medical marijuana, the recreational market is still uncharted territory, with experience in only a few places such as the Netherlands and a few U.S. states.

“The U.S. adult-use market is very dynamic, with lots of different growers, lots of companies that only do extraction [of the active ingredients in cannabis]. Brands have been built up and have a strong following,” he says. “There’s nothing like that in Canada at this point. So we’re in a bit of a wait-and-see mode.”

The Canadian companies that succeed will be those that raise a lot of capital and have strong management teams, Mr. Zandberg says.

There is also a small amount of political risk, Mr. Zandberg adds: “Everything points to the start of an adult-use market in Canada that commences some time in mid-2018, but you never want to consider anything a done deal. You can’t be naive and think that there is nothing that can stall this.”

For example, what if the Senate holds up the legislation?

The exact shape of the recreational market will affect the fortunes of individual marijuana growers and distributors, too, Mr. Zandberg says. “I’m not too worried about the provinces coming aboard [with regulations such as selling marijuana through liquor stores or pharmacies]. But if all we end up with is a mail-order business, that would be great for a lot of licensed producers, because they have huge margins from dealing direct,” he adds.